Navigating NOLs and Section 382 in M&A

Introduction: The Unseen Bedrock of Deal Value

In the realm of M&A, tax due diligence is often misunderstood as a routine compliance check. In reality, it is a foundational assessment that shapes both deal value and post-close economics. I have seen deals rise and fall not just on revenue synergies or cultural alignment, but on tax structuring failures—especially those tied to net operating losses, basis step-ups, and Section 382 limitations. These areas are deeply technical but intensely consequential.

Net Operating Losses: Timing and Limitations Matter

Net operating losses, or NOLs, offer an appealing prospect in M&A: the ability to offset future taxable income with past losses. But this benefit is far from guaranteed. In one Series B acquisition of a clean energy startup, we were drawn by its $45 million in accumulated NOLs. However, deeper diligence revealed multiple ownership changes, and the limitations under IRC Section 382 rendered the bulk of those NOLs unusable.

Under Section 382, when a company undergoes an ownership change—defined as a shift of more than 50 percent in equity by value among 5 percent shareholders over a rolling three-year period—its ability to utilize pre-change NOLs is capped. This cap is based on the company’s equity value multiplied by the IRS long-term tax-exempt rate, which is often modest.

Understanding this limitation requires not only a technical analysis but historical cap table modeling. In fast-growing startups with multiple rounds of preferred equity, pinpointing ownership shifts can be laborious but essential. In a recent case, we used software tools to reconstruct shareholder movements over seven years, revealing that three prior funding rounds had already triggered ownership changes. What seemed like a tax asset was, in practice, a footnote.

Basis Step-Up: The Quiet Driver of Cash Flow

A basis step-up—particularly one obtained through an asset deal or a Section 338 election—can dramatically impact post-close cash flows. When the buyer can revalue acquired assets to fair market value, depreciation and amortization increase accordingly, reducing future taxable income.

In a tech acquisition we pursued, the ability to step up basis on developed software and customer relationships translated into an estimated $12 million in tax savings over five years. That figure alone narrowed the valuation gap with the seller.

Yet the availability of a step-up is tightly linked to deal structure. Asset deals inherently allow for it, but stock deals do not—unless a Section 338(h)(10) or 336(e) election is available. These elections require cooperation from the seller and come with various stipulations. For example, a 338(h)(10) election is only available if the target is a subsidiary of a corporation and both parties agree.

We once structured a stock purchase of a wholly owned subsidiary with a 338(h)(10) election. While the step-up saved millions, state tax conformity was uneven, leading to mismatches in basis reporting and additional compliance burdens. Thus, modeling must account for both federal and state-level outcomes.

Section 382: More Than Just an NOL Story

Section 382 does not only limit NOLs. It also applies to built-in losses and disallowed interest deductions under Section 163(j). For acquisitive buyers eyeing distressed assets or pre-revenue startups, these limitations can erode value quickly.

We once considered acquiring a media business with $100 million in federal NOLs. On closer inspection, we discovered that under the 382 limitation, we would be able to use only $2 million annually, rendering the NOLs a marginal benefit. In such situations, the strategic play may be to negotiate the purchase price accordingly or seek other structuring options.

Furthermore, the post-change year requires complex tracking of income recognition, disallowed losses, and triggering events. Integrating this with ongoing tax provisioning under ASC 740 is nontrivial. Failure to do so may result in both IRS penalties and auditor scrutiny.

Due Diligence in Practice: What Great Looks Like

Best-in-class tax diligence goes far beyond reviewing returns. It includes modeling ownership change triggers, assessing 382 limitations, and scenario planning around tax attributes. We routinely overlay this analysis with financial modeling to reflect real cash flow impact.

In one Series D SaaS acquisition, our diligence team constructed a dynamic workbook modeling potential 382 limits under varying change-in-ownership paths. This allowed our board to assess three deal structures side by side, comparing net present value impacts over a five-year horizon. That level of clarity often makes or breaks executive alignment.

Tax diligence also must include reviewing the target’s historical tax positions. In particular, we examine uncertain tax positions under ASC 740-10 (formerly FIN 48), carryforward schedules, R&D credit substantiation, and international compliance gaps. In one case, unrecognized VAT liabilities in three EU countries nearly derailed a transaction.

Coordination with Financial Reporting

Post-close, the alignment between tax diligence findings and financial reporting must be seamless. If NOLs are found to be impaired, deferred tax assets may need to be written down. Similarly, any 338 election must be reflected in the opening balance sheet, with corresponding goodwill and deferred tax liabilities recorded appropriately.

In my experience, disconnects between tax diligence and accounting have led to embarrassing restatements or audit friction. The CFO’s job is to ensure continuity from diligence to close to financial reporting.

Conclusion: Tax Is Not a Backroom Function. It Is a Strategic Lens.

Tax diligence is not just about downside protection. It is about unlocking latent value and aligning structure with financial goals. In a world where margins are scrutinized and synergies must be proven, the tax lens often uncovers both risk and opportunity invisible to operational teams.

CFOs must demand not only thoroughness but synthesis. The best tax diligence is not a stack of memos, but a strategic narrative that informs negotiation, pricing, and structure. When done right, it elevates the deal from a tactical transaction to a strategic inflection point.

Insight

Over my career, I have watched the difference between good deals and great ones often hinge on tax diligence—not in the headlines, but in the modeling assumptions, buried elections, and footnotes of carryforward schedules. Most deals go wrong not because of what the buyer didn’t see, but because of what they didn’t ask. Tax due diligence, especially in areas like NOLs, basis step-up, and Section 382, is where much of that critical questioning must take place.

Net operating losses can appear on a balance sheet like a goldmine waiting to be tapped. But unless the mechanics of Section 382 are fully understood and modeled, that mine often turns out to be a mirage. In one startup acquisition, we discovered too late that a prior secondary sale had already triggered an ownership change, and our 60 million dollars of NOLs were now subject to a 2.4 million dollar annual cap. That reduced our expected tax shield by more than 80 percent. It changed our view of the valuation and should have changed the price. We learned the hard way.

The deeper lesson here is that NOL analysis is as much about historical reconstruction as future forecasting. Understanding the cap table across multiple funding rounds, teasing out 5 percent shareholders, and reconstructing transactional control events is non-trivial, especially in Series B to D companies with layered capital structures. But it is essential. We now standardize a practice where, within the first week of diligence, our tax team begins a 382 analysis with full cap table access. If sellers hesitate, we flag it.

Basis step-up, by contrast, is a quieter but just as potent lever. If the buyer can increase the tax basis of assets to fair market value, the resulting amortization can enhance free cash flow significantly. In many deals, we have used this strategy to justify a higher headline purchase price. But like all advantages, it depends on structure. Asset deals allow for this naturally, but they are rare due to contract assignment and license disruption. Stock deals can simulate it via 338(h)(10) elections, but only under specific conditions.

In one case, we negotiated with a corporate seller to elect 338(h)(10) in exchange for a modest gross-up on purchase price to cover their tax liability. The economics worked for both parties because we projected $10 million in NPV savings from amortization over five years. That was not luck. It was structure.

Yet even when structure is favorable, one must model the consequences beyond federal tax. State conformity with 338 elections is inconsistent. Some states accept the election; others do not, leading to divergent basis schedules, deferred tax entries, and compliance overhead. That must be factored into your purchase accounting and ERP integration plan.

Section 382 is not just about NOLs. It also limits the use of built-in losses and impacts the applicability of Section 163(j) limitations on interest deductibility. In leveraged acquisitions, this can be a double blow. The buyer expects to use both NOLs and interest deductions to manage post-close tax expense, only to find that Section 382 and 163(j) working in tandem wipe out much of that benefit. Our standard practice now includes a joint limitation model to quantify this precisely.

This level of modeling is not optional. In one complex acquisition, our diligence flagged that post-close, under 382, we could only utilize a fraction of the NOLs and none of the built-in losses for five years. The board decided to walk from the deal. A competitor who lacked that insight closed it, only to announce a goodwill impairment two years later. There is nothing more valuable than information that prevents you from making the wrong decision.

Best-in-class tax diligence also looks forward. It integrates with ASC 740, ensuring that deferred tax assets are properly recorded, that uncertain tax positions are recognized, and that the financial statements tell the truth investors need. It works with audit teams to ensure consistency between diligence findings and opening balance sheet entries. And it translates risk into negotiation language—warranties, indemnifications, and post-close reserves.

This discipline has allowed us to find leverage points in almost every deal. When tax liabilities were unknown, we negotiated escrow. When NOLs were limited, we negotiated price. When basis step-ups were achievable, we offered to share benefits with the seller. It turned tax from a back-office function into a boardroom asset.

Ultimately, tax due diligence is not about avoidance. It is about clarity. It helps you see the true cost and value of what you are buying. It helps you structure better, negotiate smarter, and integrate cleaner. And when the inevitable surprises arise, it ensures you are prepared, not panicked.

If there is one message I would leave to any CFO preparing for an acquisition, it is this: elevate tax diligence to a first-order priority. Give it the same visibility and scrutiny you would give to revenue projections or customer concentration. Because when appropriately structured, tax attributes can turn a good deal into a great one. And when neglected, they can do exactly the opposite.

Disclaimer: This article is for informational purposes only and does not constitute legal, tax, or financial advice. Always consult qualified advisors before making decisions on M&A structure or execution.